Sep 22, 2011

Variance Risk Premium In VIX Options

I just came across a very interesting research paper: Quantifying the Variance Risk Premium in VIX Options by Reed M. Hogan. Even though the work is a college senior thesis, it is a quality research and I believe one of the first papers on the subject!

If you have read Jared Woodard's Options and the Volatility Risk Premium you know about volatility risk premiums for different asset classes like equities and commodities. Now with proliferation of trading products on VIX and VSTOXX, it is important to measure the risk premium embedded in VIX options. The author explains the methodology developed by Peter Carr and Liuren Wu to create synthetic var-swap on VIX options (please note, there is a plus sign missing in the formula [1]), but uses a different formula that is developed by Gatheral. Realized volatility is computed from corresponding futures contract that has at least 12 days until expiration. The author then tests simple call and put writing strategies on the VIX.

Abstract:
This thesis uses synthetically created variance swaps on VIX futures to quantify the variance risk premium in VIX options. The results of this methodology suggest that the average premium is -3.26%, meaning that the realized variance on VIX futures is on average less than the variance implied by the swap rate. This premium does not vary with time or the level of the swap rate as much as premiums in other asset classes.  A negative risk premium should mean that VIX option strategies that are net credit should be profitable.  This thesis tests two simple net credit strategies with puts and calls, and finds that the call strategy is profitable while the put strategy is not.


7 comments:

  1. Anonymous10/14/2011

    log strips on underlying dynamics as frought with jumps as VIX futures necessarily make estimates unsuitable for use in pinning down the size and perhaps even the sign of the premium in question

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  2. Very good point, anonymous. Do you know of any research that addresses robustness of premium estimates?

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  3. Anonymous10/15/2011

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    not off the top of my head -- though the approach described in the following is one that i believe is worth one's time to think about and then some, despite the rather strong assumption of independence between vol and its underlying (of course this assumption gets relaxed.) It deals with pricing but one can use the ideas here to re-examine the problem in question. Also Bruno Dupire contributed to this question in his work on the fair value of VIX futures, which implicitly requires estimates of the 'real world' variance risk premium.

    http://www.math.uchicago.edu/~rl/OVSwithAppendices.pdf

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  4. Anonymous10/15/2011

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    Is there any way you could get your hands on the following publication issued by Barclays?

    Index Volatility Weekly – Valuing Vol of Vol– September 28, 2009

    Thanks

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  5. You can search "Variance Risk Premia" in Federal Reserve website,and you'll see several woking papers there

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  6. You can search "Variance Risk Premia" in Federal Reserve website,there are several working papers there

    ReplyDelete